Knowing how to calculate cap rate in real estate is a key skill for any investor, but understanding what to do with it is even more important. If you've ever wondered what is a good cap rate for commercial real estate or what is a good cap rate for residential rental property, the honest answer is "it depends." However, with the right benchmarks and calculation methods, you can get a clearer picture of how your property is performing.
In this blog, we'll break down the basic formulas, the data you need to make the calculations, common mistakes to avoid, and how to benchmark cap rates across different property types.
How to Calculate Cap Rate in Commercial Real Estate
Your Capitalisation Rate ("Cap Rate") is calculated by dividing your property's net operating income (NOI) by its current market value or purchase price. This straightforward process involves several critical steps:
- Calculate your Gross Potential Income (GPI), i.e. the maximum total income you could generate if your property was fully rented out.
- Estimate and subtract your vacancy and collection losses to give a true picture of what you can expect from rent.
- Add other income sources (parking, laundry, etc.) to account for all your income.
- Use these figures to calculate Effective Gross Income (EGI).
- Subtract all operating expenses including maintenance, utilities, and tax.
- Combine these figures to determine your Net Operating Income (NOI), i.e. your true income after deducting expenses.
- Apply the Cap Rate formula: Cap Rate = NOI ÷ Property Value × 100%
This calculation method directly relates to the risk assessment framework we discussed in our previous article on understanding cap rates and risk relationships. The more accurately you calculate your NOI, the better you can assess the true risk-return profile of your investment.
Critical Components for Accurate NOI Determination
If you don't apply all these steps carefully, you risk doing a lot of maths for not a lot of information. To ensure the most accurate calculation, ensure that you:
Account for Vacancy Allowances by asking yourself these questions:
- What are the typical vacancy rates in your market? Typically, they are 3.0% - 8.0% but your location and sector have a big impact.
- What collection losses can you expect? Be realistic.
- How long will it really take to fill vacancies when leases come to an end?
Account for Tenant Incentives by asking yourself these questions
- What type of incentive needs to be provided to incoming tenants? Typically, these in the form of rent free allowances, cash incentives, or contributions towards a tenants fitout costs.
- When are the tenant incentives payable?
- Are the tenant incentives a one off lump sum, or will they occur throughout the duration of the lease term?
Account for Tenant Rental Escalations by asking yourself these questions
- What type of rental escalations are provisioned within the lease? Typically, these will be a fixed percentage or tied to an index such as CPI.
- Are the rental escalations capped each year?
- What will happen to the tenant’s rental rate at the end of the lease term? Will it be marked to the market rate?
Include all your operating expenses by assessing each of these categories:
- Property management fees: Professional management typically costs 3.0-5.0% of EGI, varying based on property size and complexity. Even if self-managing, you should account for this expense to reflect the true operational cost.
- Property taxes: Use current tax assessments rather than estimates, and anticipate potential increases based on local government trends and property value reassessments.
- Insurance premiums: Ensure you're calculating based on appropriate coverage levels for your property type and location.
- Tenant-responsible utilities: Include any utilities not explicitly passed through to tenants in your lease agreements. This often includes common area utilities and any service interruptions that aren’t recovered from the service charge.
- Repairs and maintenance: This typically ranges from 5.0-10.0% of EGI, with older properties requiring the higher end of this range. Track your maintenance history to establish property-specific benchmarks.
- Common area maintenance (CAM): Even if partially recoverable from tenants, ensure you're accounting for any shortfalls or owner responsibilities clearly specified in leases.
- Capital expenditure reserves: Set aside 2.0-4.0% of EGI for major repairs or replacements to building systems like HVAC, roofing, or other significant infrastructure that is not paid by the tenants.
It can be tempting to exaggerate your potential income or exclude expenses to make yourself feel better about your investment, but the only person you're fooling is yourself. Underestimating expenses by even 5% can significantly skew your cap rate calculation and lead to poor investment decisions. You need to be realistic now to avoid a nasty valuation shock or income shortfall down the line.
What is a Good Cap Rate for Commercial Real Estate?
A good cap rate depends on your property type, location, and your investment goals. The riskier the property, the higher you will generally want the cap rate to be. Riskier properties tend to have less appeal and higher vacancy rates, meaning a lower resale value and longer periods of low or no income. That means you want a higher income to cover your risk and that means a higher cap rate.
You should always research comparable properties and your local market, but below you can find some basic benchmarks and guidelines to help you get started:
Property Type
- CBD Office: 4.5% - 6.5%
- Suburban Office: 6.0% - 8.0%
- Neighborhood Retail: 5.5% - 7.5%
- Regional Shopping Centers: 5.0% - 7.0%
- Industrial/Logistics: 5.0% - 7.5%
- Medical/Healthcare: 5.5% - 7.5%
Different property types have different cap rate ranges primarily due to their risk profiles, as we explored in our previous discussion on property types and risk factors. Office properties in CBD locations typically have lower cap rates because they attract premium tenants with stronger covenants, while suburban offices face higher tenant turnover, shorter lease terms, high vacancies, and market volatility.
Location Quality
- Prime locations: typically 100-150 basis points lower
- Secondary locations: require higher yields
- Emerging markets: highest return expectations
Asset Quality Tiers
- A-Grade: lowest Cap Rates, typically 4.5-6.0%
- B-Grade: mid-range Cap Rates, typically 6.0-7.5%
- C-Grade: highest Cap Rates, typically 7.5-9.5%
What is the Average Cap Rate for Commercial Real Estate?
Current Australian Market Averages for cap rates as of early 2025 are:
- Sydney CBD Prime Office: 4.50% - 5.50%
- Melbourne CBD Prime Office: 4.75% - 5.75%
- Brisbane CBD Prime Office: 5.50% - 6.25%
- Perth CBD Prime Office: 5.75% - 6.25%
- Prime Retail (Super Regional): 5.00% - 5.50%
- Neighborhood Retail Centers: 5.75% - 6.75%
- Prime Industrial/Logistics: 4.75% - 5.75%
- Secondary Industrial: 6.25% - 7.25%
How to Figure Cap Rate on Residential Property
Residential properties are different from commercial in that there is a little less variation and complexity to deal with, but you're also less likely to pass management and maintenance costs onto tenants. Calculating your cap rate for rental property does follow very similar principles but there are some key differences.
Firstly, when it comes to single-family residential properties, expense ratios are typically much higher, around 35 - 50% of gross income. You'll also always need to account for management fees in a residential property. Vacancy, on the other hand, can be lower, with a typical range of 2.0 - 8.0% in residential properties depending on the market conditions and location.
In multi-family properties, you get more economies of scale, but you need to account for the cost of maintaining common areas. In particular, you need to account for reserves for repairs and replacements, with most strata properties having sinking funds in place.
Residential investors are less likely to adjust for temporary income fluctuations to reflect a property's long-term earning potential, as commercial investors do. Finally, whereas residential properties are often valued based on similar recent sales, commercial properties are mostly valued based on their income generation, making cap rate calculations more detailed.
What is a Good Cap Rate for Residential Rental Property?
Like commercial investing, it's always a good idea to look at comparable properties and your local market but, as a benchmark, the figures below can provide a starting point. Good residential rental cap rates in Australia typically range:
- Capital city apartments: 3.5% - 5.0%
- Regional city apartments: 5.0% - 6.5%
- Metropolitan houses: 3.0% - 4.5%
- Regional houses: 4.5% - 6.0%
- Student accommodation: 5.5% - 7.0%
- Workforce housing: 5.0% - 7.0%
Australian Residential Investment Yields and Benchmarks
Residential and commercial properties in Australia can have very different risk profiles and growth expectations. As we detailed in our previous article on risk and value relationships, investors often accept lower yields on residential properties because they traditionally offer stronger capital growth potential compared to commercial assets.
As of early 2025, gross residential yields average 3.0% - 4.5% in capital cities and 4.0-6.0% elsewhere. Houses generally deliver a yield 0.5% - 1.0% lower than apartments in the same location because land values are higher. Investor-grade properties in high-rental demand areas such as university precincts or employment hubs may achieve yields 0.5% - 1.0% higher than the market average.
In blue chip suburbs, you might accept lower initial yields (3.0-3.75%) with the expectation that you can achieve stronger capital appreciation and benefit from historically proven stability. These premium locations typically offer lower risk profiles due to consistently strong demand, limited supply, and resilient property values even during market downturns. Meanwhile, stable regional markets typically require yields above 5.0% to compensate for expectations of lower growth potential, potentially lower liquidity, and greater susceptibility to local economic fluctuations.
When calculating residential yields, you should account for:
- Vacancy rates (typically 2.0% - 4.5% in strong markets)
- Management fees (7.0% - 8.5% of gross income)
- Leasing fees
- Maintenance reserves (1.0% - 1.5% of property value annually)
- Council rates
- Land tax (varies by state)
- Strata/body corporate fees
- Insurance (landlord insurance)
- Compliance costs (smoke alarm testing, safety inspections, etc.)
- Any other ownership costs
With all these costs accounted for, you should expect to arrive at net yields that are typically 1.5 - 2.0% below gross figures.
Common Cap Rate Calculation Mistakes
Calculating your cap rate relies a lot on your own judgment and record keeping. Mistakenly including or excluding a large expense could throw your calculations off and, in turn, lead you to make poor decisions about the future of your investments.
What are the most common errors investors make when calculating their cap rate? These are just a few examples:
- Including interest payments in expenses (these are finance costs, to operating costs)
- Excluding management fees for self-managed properties.
- Omitting replacement reserves in multi-family properties.
- Using inconsistent vacancy rates.
- Failing to normalise one-time expenses for a more realistic long-term outlook.
- Ignoring market rent for owner-occupied space (i.e. space that the investor uses themselves).
- Overlooking land tax and council rates in expense calculations.
- Failing to normalise one-time expenses for a more realistic long-term outlook.
Your cap rate is a vital indicator of how your commercial investment property is performing but remember it's never as simple as a high cap rate being good and a low cap rate being bad. Depending on your circumstances, location, and type of property, a low cap rate could be an indication of poor performance or strong capital growth.
How you interpret your cap rate might change, therefore, but whatever your strategy you need to calculate your cap rate accurately and account for all the relevant expenses and income. That starts with good record keeping and ends with intelligent benchmarking. Know your property and know your market and you're on the road to success.
Calculating your cap rate can be a complicated exercise, but an invaluable one. By putting in the effort now, putting processes in place to collect and monitor the figures you need to make the calculations, you can stay ahead and stay informed.
Frequently Asked Questions About Cap Rates
How do I calculate cap rate in real estate?
To calculate cap rate in real estate, divide your Net Operating Income (NOI) by the property's current market value, then multiply by 100 to get a percentage. Remember to calculate your NOI accurately by including all income sources and subtracting all operating expenses (but not finance costs, such as interest and principal repayments).
What is a good cap rate for real estate?
A good cap rate for real estate depends on property type, location, and market conditions. Generally, prime commercial properties might have cap rates of 4.5% - 6.5%, while premium residential properties typically range from 3.0% - 5.0%. Higher-risk properties should command higher cap rates to compensate for increased uncertainty.
How do I figure cap rate on rental property?
To figure cap rate on rental property, calculate your annual rental income, subtract all operating expenses (including management fees, maintenance costs, property tax, insurance, and vacancy allowances), then divide this NOI by the property value and multiply by 100. For residential rental properties, be especially mindful of higher expense ratios compared to commercial properties.
What makes a good cap rate for residential rental property?
A good cap rate for residential rental property typically ranges from 3.0% - 6.5% depending on location and property quality. Capital city properties usually have lower cap rates (3.5% - 5.0%) due to higher growth potential, while regional properties command higher cap rates (4.5% - 6.5%) to compensate for potentially lower capital growth.
